Tag Archives: Financial Crisis

Forces that caused the world economy to collapse, including income inequality and debt, are again in action, and could drag corporations down in their wake

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Our macro models at the Levy Economics Institute are showing that the US economy is about to face a repeat of pre-crisis-style, debt-led growth, based on increased borrowing. Falling government deficits are being replaced by rising debts on everyone else’s ledgers – well, almost everyone else’s.

What’s emerging is a new sort of speculative bubble, this time based on consumer and corporate credit.

Right now, America is wrestling a three-headed monster of weak foreign demand, tight government budgets and high income inequality, with every sign that these conditions will continue. With that trio in place, the anticipated growth isn’t going to be propelled by an export bonanza, or by a government investment boom.

The future might very soon remind us that, for over a quarter of a century, a major financial and economic crisis has occurred every seven years:

• In October 1987, the Dow Jones industrial average lost 22.6% of its value in a single day; …

• In December 1994, while a euphoria (“bubble”) of internet-based companies was being pumped up in Silicon Valley, the nearby Orange County turned to derivatives-based speculation, and filed for bankruptcy; a little later, a brutal and brief Asian currency and financial crisis, spread in Russia, Brazil, and then in the United States. Here again, the Fed managed to bring the situation under control.

• By April 2001, the dot-com bubble, that was formed over the past five years, burst; …

• In the summer of 2008, the bursting of the housing (mortgage-backed security – MBS) bubble triggered a new crisis, truly global this time. …

We are nearing the end of a new seven-year period. Bubbles have formed again everywhere. …

Five years later, the effects of the financial crisis are still with us. The question is whether they always will be.

It’s called hysteresis, and it’s a simple, if terrifying, idea: A deep recession can cause irreparable damage to the economy. That’s because an anemic labor market can turn into a persistently smaller one. The long-term unemployed might become unemployable, and people who want full-time jobs could think things are so bad that they might not even look for work at all. Not only that, but too little investment today might make us less productive tomorrow. Add it all up — fewer and less efficient workers — and a weak recovery can beget weaker growth, forever.

There’s already concern that the Great Recession and the not-so-great recovery have permanently made us poorer. …

The world has known since Reinhart and Rogoff’s classic “This time is different” that financial crises are likely to cause persistent damage to economies. Even if growth returns to pre-crisis rates (and that is a big if), the level of output is generally lower. Persistently lower output is horrible as it generally requires households, governments and companies to tighten their belts in order to bring spending into line with the new expectations they are poorer than they had hoped.

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First, the OECD agrees with Reinhart and Rogoff, saying: “For most OECD countries, the crisis has probably resulted in a permanent loss of potential output, so that even with a continuing recovery, GDP may not catch-up to its pre-crisis trajectory”.

A financial crisis in China has become inevitable. If it happens soon, its effects can be contained. But, if policy makers use further doses of stimulus to postpone the day of reckoning, a severe collapse will become unavoidable within a few years.

The country is in the middle of by far the largest monetary expansion in history. On one widely used measure, M2, its money supply has tripled in the past six years, an expansion four times as large as that of the US over the same period.

With the 2008 financial crisis is still fresh in the mind of many investors, it would appear that the world is setting itself up for another collapse. However, this time it could be much worse.

A seven-year high

One of the root causes of the last financial crisis, was the use and availability of collateralised loan obligations, or CLOs for short. CLOs are bundles of loans packaged together as one tradeable security, designed to help boost returns for yield-hungry investors.

Now, in theory, these CLOs are safe, if the loans used to construct them are high quality. Unfortunately, as investors are increasingly searching higher returns, lower-quality loans are being used within CLOs for their higher interest rates.

As a result, sales of CLOs have boomed during the past few months hitting a level not seen since May of 2007, just before the financial crisis took hold. Unsurprisingly, this puts banks with the biggest investment banking divisions at risk, Barclays(LSE: BARC)(NYSE: BCS.US) in particular.

WE LIVE in a world riddled with black swan fatigue, and this piece does not propose to add to it. Still, the recent financial crisis and its continuing implications have invited hyperbolic comparisons, most notably with the 1930s. That decade is seared in cultural memory as the Great Depression – a traumatic time of economic distress and mass unemployment. Yet it was also one of the most successful eras for entrepreneurs in US history, with more fortunes created than in almost any other comparable period. Among the companies founded were Motorola (1928), KFC (1930), Tampax (1936) and Hewlett-Packard (1939).

This conundrum reveals some important truths. First, no country ever went bust forever. In the middle of even the most troubled economic environment, there are embers waiting to spark into life and produce future growth. Second, innovation is in our blood. Capitalism is a continual process of creative destruction, where markets periodically clear out the old and replace it with the new. This agnostic dynamism is fundamental to our ability to adapt to a changing environment and find ways forward.

In short, economies are dynamic pools of exchange beset by continual paradigm shifts, thanks to the inconsistent behaviours of their human constituents. These shifts may be good – innovation and booms – and may be bad – over-extension and busts. Common to both is the complex web of money and credit that binds us together.

“Common to both is the complex web of money and credit that binds us together.”

In other words, it is the connectedness of society that accelerates the race to crisis. This happens within a society, and it happens globally. Given that we want connectedness, then how can we avoid the big crisis? What about automatic debt release every 7 years? That’s the equivalent of democratic elections for the economy. In this case the people who pay are the ones making stupid economic decisions.

We’re relearning an old lesson: History, culture, geography, religion and pride often trump economics. The nation-state remains, reminds Harvard political scientist Jeffry Frieden, author of “Global Capitalism: Its Fall and Rise in the Twentieth Century.” It defines its interests on its terms. Putin, not illogically, sees Russia threatened on its borders by an American-led coalition that, Frieden says, “is hostile in the sense that most people in the West would like to see Putin’s regime go — it’s authoritarian; it frustrates our interests.”

Globalization could never swamp everything else. Economics is not omnipotent. …

Connectedness (globalization) actually facilitates war which is pretty much the opposite of what we have been told by western experts. The problem is that connectedness facilitates the transmission of problems (contagion) – like a big financial crisis. A big crisis in one area gets transmitted around the world beginning the process of destabilization and/or weakening. Nondemocratic type regimes start experiencing increased economic problems which push a regime in the direction of revolution. In seeking ways to compensate, some leaders move in the direction of a more aggressive foreign policy. We are seeing this effect with both Russia and China today.

The last age of globalization resembled the current one in numerous ways. It was characterized by relatively free trade, limited restrictions on migration, and hardly any regulation of capital flows. Inflation was low. A wave of technological innovation was revolutionizing the communications and energy sectors; the world first discovered the joys of the telephone, the radio, the internal combustion engine, and paved roads. The U.S. economy was the biggest in the world, and the development of its massive internal market had become the principal source of business innovation. China was opening up, raising all kinds of expectations in the West, and Russia was growing rapidly.

[1.] The first cause was imperial overstretch. By 1914, the British Empire was showing signs of being a “weary Titan,” in the words of the poet Matthew Arnold. …

[2.] Great-power rivalry was another principal cause of the catastrophe. The problem was not so much Anglo-German rivalry at sea as it was Russo-German rivalry on land. …

[3.] The third fatal factor was an unstable alliance system. Alliances existed in abundance, but they were shaky. …

[4.] The presence of a rogue regime sponsoring terror was a fourth source of instability. The chain of events leading to war, as every schoolchild used to know, began with the assassination of the Austrian Archduke Franz Ferdinand in Sarajevo by a Bosnian Serb, Gavrilo Princip. …

[5.] Finally, the rise of a revolutionary terrorist organization hostile to capitalism turned an international crisis into a backlash against the global free market. …

Causing concern both at home and abroad, the Chinese company Zhejiang Xingrun Real Estate recently collapsed under the weight of 3.5 billion yuan ($566.6 million) of debt.

The announcement comes just one week after China’s first onshore bond market default in over a decade, which investors already suggested might be the country’s “Bear Stearns” moment, leading up to a financial crisis. Xingrun’s collapse adds to analysts’ concerns that China’s economy, and the real estate market in particular, is in serious trouble.

Beyond concerns for China alone, some in the financial community are concerned about the intersection of a Chinese economic crisis with Crimea’s political woes, since China and Russia are major trading partners.

The scars are still raw five years after one of the worst financial crises in modern memory came to an end. Ever since the Dow Jones Industrial Average (DJINDICES: ^DJI) bottomed out in 2009, investors have been bombarded by warnings and predictions of imminent collapse from every corner of the punditsphere, and millions have listened, choosing to stay on the sidelines to nurse their portfolio’s wounds.

But the prophets of doom haven’t been right so far. The global economy, while not as robust as it could be, is hardly in freefall. Our most recent financial crisis, while undoubtedly hugely important in our own lives, simply isn’t as transformative as some of history’s worst economic collapses. It changed our lives, but the world continues to operate much as it did before.

To understand how transformative a financial crisis can truly be, let’s look back at five historical collapses that actually changed the course of history. These events toppled empires, altered economies, and shifted the global balance of power in ways few of us have experienced in our lifetimes. Let’s start with the most recent event, the one against which our latest crash is often measured.